Term structure modeling and forecasting using the nelson-siegel model

Abstract

In this chapter, we illustrate some recent developments in the yield curve modeling by introducing a latent factor model called the dynamic Nelson-Siegel model. This model not only provides good in-sample fit, but also produces superior out-of-sample performance. Beyond Treasury yield curve, the model can also be useful for other assets such as corporate bond and volatility. Moreover, the model also suggests generalized duration components corresponding to the level, slope, and curvature risk factors. The dynamic Nelson-Siegel model can be estimated via a one-step procedure, like the Kalman filter, which canalso easily accommodate other variables of interests. Alternatively, we could estimate the model through a two-step process by fixing one parameter and estimating with ordinary least squares. The model isflexible and capable of replicating a variety of yield curve shapes: upward.